Just as it’s smart to question the doctor suggesting test after test for you at a facility he or she owns, it’s important to know how your financial advisor’s pay structure creates incentives that may harm or help your portfolio in the long run.
Let’s review the various ways there are for you to pay a financial advisor as well as the various ways a financial advisor can get compensated for how he/she “manages” your portfolio.
So says Patrick Clark (wealthfront.com) in edited excerpts below from two of his articles*.
Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has edited and combined below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.
Clark goes on to say:
The SEC tells investors that, before you hire any financial professional—whether it’s a stockbroker, a financial planner, or an investment advisor—you should always find out, and make sure you understand, how that person gets paid.
A. How you pay your advisor
The key questions you should ask your advisor about how you pay him/her are:
- How much will you charge me, and what are your fees based on?
- Is that compensation structure best for my particular situation?
There are 3 different compensation models in the business. Each creates its own incentives.
1. Fee on assets under management
When an investor pays his advisor on a percentage of assets under management, the fee is typically deducted from the assets, often on a quarterly basis. The typical fee is 1% of assets under management, but I have known it to range from .75% for large portfolios, up to 2% for small ones. If you’re paying a fairly typical 1% fee on $100,000 under management, and your assets remain at $100,000 at the end of the quarter, you’ll pay a fee of $250, or one-fourth the annual charge of $1,000.
A fee on the assets under management gives your advisor an incentive to grow your assets because his or her fee will grow at the same time. Some have argued that the fee model may create an incentive for advisors to grow your assets fast, and take too much risk…An advisor who seeks to create a long-term relationship with you, however, is less likely to do that. Over time, the fees on a well-managed account add up to more than the quick-hit fees on a fast-growing one if the bottom then falls out of the market.
If [the advisor] tells you that he/she charges a fee on assets under management, specifically ask if she also is paid via commission or if there are services for which you’ll be charged an hourly fee. If her response to your question about payment revolves around commissions or an hourly fee, ask about the other two categories of pay, as well.
Some advisors, especially those that are licensed as brokers, are paid by commission on the securities they buy and sell for you. Commission-based pay creates an incentive for advisors to buy and sell securities. Excessive buying and selling, studies have shown, is the biggest drag on investor portfolios… However, if you have a large portfolio, and you trade infrequently, you may well end up paying less in commissions than you would to a fee-based advisor. A key thing to watch out for with an advisor paid on commission is very frequent rebalancing of your portfolio. If you’re rebalancing four times a year or more, and your advisor can’t give you a good rationale for it, look deeper.
3. Hourly fee
Some advisors charge an hourly fee, often to help you organize your entire financial life. An hourly fee is much like the lawyer model: the investor is billed for the time that his advisor is working for, talking to, or thinking about him. Some people have argued that the hourly billing model should be adopted in a more widespread fashion by the investment advisory business because it steers clear of all the issues raised by the two models above.
Hourly billing creates its own perverse incentives, as lawyer-turned-author Scott Turow argues saying: “Who ever says to a client that my billing system on its face rewards me at your expense for slow problem-solving, duplication of effort, featherbedding the workforce and compulsiveness—not to mention fuzzy math?”
His answer, basically, is that nobody does.
These days, many advisors use a combination of the models above to charge you for their services. A fee-only advisor may charge clients an hourly or fixed fee for the creation of a financial plan, plus a percentage of assets under management, just as an advisor who is also a broker-dealer may charge a percentage of assets in addition to commissions on transactions.
The bottom line is that nobody has devised a perfect way of paying a professional like a doctor, lawyer or investment advisor. The best a patient, client or investor can do is to be aware of the incentives built in to the system and be educated about how they are affecting your own advisor.
As investor advocate and University of Mississippi law professor Mercer Bullard points out, every pay structure creates its own peculiar incentives, saying:
“The fundamental tension has always been that if you have a commission-driven compensation structure, you might encourage high turnover. If you have an asset-based fee structure you might encourage a do-nothing approach.”
B. How advisors get paid
In addition to the money you pay your advisor, he/she may receive other kinds of compensation. It’s crucial to follow that money, too, because that’s how you can figure out if the money you’re paying the advisor is dwarfed by the amount a mutual fund company or a bank is paying him to sell you their products.
If advisors all worked for themselves, it would be far simpler to understand how they were compensated. In most cases, however, advisors are employees of companies that generate revenue by many means – by charging commissions, by creating investment products and by selling investment products for other companies, such as mutual fund companies. The companies that employ advisors range from the big Wall Street names, like Merrill Lynch and Morgan Stanley Smith Barney, to smaller local brokerage houses, to big insurance companies like Allstate.
The corporations’ sources of revenue help determine how your advisor gets paid, and help determine the incentives as he creates and manages your portfolio. The compensation from these big companies often is structured to enrich the companies, not to grow your portfolio. Many conflicts of interest arise when you consider how advisors are compensated by their companies. We identify three of them [below, as follows:]…
1: Sales vs. Performance
a) The payment of that big bonus – which can equal hundreds of thousands of dollars for some Wall Street advisors – usually hinges both on the bank’s performance and on the advisor hitting certain targets, such as new clients. The top “producers” on the street are paid more not for earning higher returns on portfolios, but for bringing in new clients, preferably the wealthy ones. Obviously, those bonuses encourage advisors to spend more time drumming up business, and less time managing their accounts…
b) Advisors at independent firms also work on salary plus bonuses that typically fall between 20% and 200% of salary. Registered Investment Advisor firms will sometimes entice advisors to switch firms by offering a yearly percentage of revenues generated by assets the advisors bring with them.
c) Advisors who are employed by broker-dealers, or who are the employees of broker-dealer divisions of big banks, usually earn a straight draw on commissions, sometimes as much as 50%. The incentive there is obvious: The more trades a client makes, the more the employee earns.
2: Proprietary Products
The most pernicious and hard to find compensation comes from the sale of particular products. Wall Street banks and insurance companies may offer their advisors bonuses to sell so-called proprietary products, or particular funds from particular mutual fund companies. For instance, you may have an advisor from XYZ Investment Bank. If you have XYZ Investment Bank funds in your portfolio, chances are good that your advisor was paid extra for selling you those funds, whether the compensation was in the form of cash, or a fancy trip for top “producers” at the bank…
Revenue-sharing [is where] mutual funds offer sales bonuses to encourage broker-dealers to sell a specific fund. Those sales bonuses often flow to the companies that employ advisors and are paid out as bonuses or other compensation. Those bonuses may encourage advisors to sell funds that aren’t the best for you…
It would be easy to believe that the way advisors get paid doesn’t affect the way they manage your portfolio, or the time they spend thinking about your portfolio. It would be easy, but, the experts say, naïve. The truth of the matter is that how someone is paid will be the reflection of how they act. That is something it will pay to keep in mind when hiring an investment advisor.
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